Friday, June 12, 2009

Using the Fed's Flow of Funds (Z.1) report allows readers to calculate overall corporate leverage: a quick and dirty proxy for a top down leverage analysis. Much in the same way that corporate leverage is derived, the Z.1 provides the data needed to calculate the ratio of net debt to LTM internal funds/adjusted after-tax profits. This is a holistic number that does not stratify based on credit quality so IG and HY get commingled in this calculation (thus keeping it simplified and allowing historical apples to apples comparisons).

Q1 corporate leverage was 1.34x, unchanged from Q4 2008, a level higher than at any point over the past quarter of a century. Comparable prior peaks have lead the HY default rate by on average 9 months in 90-91 and 01-02, implying an expected peak of corporate defaults in early 2010. What is a bigger threat is that once all the external benefits from assistance and stimulus programs wears off, the "peak" could end up being merely a blip in an accelerating upward trajectory. As Bank Of America points out: "we remain concerned that we can be witnessing a temporary stabilization in this ratio, similar to the highlighted 1989 episode, which can then take us to the second leg of deterioration to new highs. In this case default cycle is likely to be pushed well into the future, with an uncertain peak levels. Performance of this ratio over the next few quarters would be crucial in answering this question."

Using the Fed's Flow of Funds (Z.1) report allows readers to calculate overall corporate leverage: a quick and dirty proxy for a top down leverage analysis. Much in the same way that corporate leverage is derived, the Z.1 provides the data needed to calculate the ratio of net debt to LTM internal funds/adjusted after-tax profits. This is a holistic number that does not stratify based on credit quality so IG and HY get commingled in this calculation (thus keeping it simplified and allowing historical apples to apples comparisons).

Q1 corporate leverage was 1.34x, unchanged from Q4 2008, a level higher than at any point over the past quarter of a century. Comparable prior peaks have lead the HY default rate by on average 9 months in 90-91 and 01-02, implying an expected peak of corporate defaults in early 2010. What is a bigger threat is that once all the external benefits from assistance and stimulus programs wears off, the "peak" could end up being merely a blip in an accelerating upward trajectory. As Bank Of America points out: "we remain concerned that we can be witnessing a temporary stabilization in this ratio, similar to the highlighted 1989 episode, which can then take us to the second leg of deterioration to new highs. In this case default cycle is likely to be pushed well into the future, with an uncertain peak levels. Performance of this ratio over the next few quarters would be crucial in answering this question."